Chapter 11

Chapter 11
Classical
and Keynesian
Macro Analyses
Introduction
The most commonly used gauge of volatility in U.S.
financial markets is the VIX index.
During the severe 2008 2009 recession, the VIX index
increased substantially, indicating significant variability
in the value of financial claims and interest rates.
How can disturbances in financial markets sometimes
translate into reductions in real GDP and perhaps even
into a decline in the overall price level?
In Chapter 11, you will develop an understanding of
how to answer this question by learning about how the
equilibrium price level is determined in the short run.
Copyright 2014 Pearson Education, Inc. All rights reserved.
11-2
Learning Objectives
Discuss the central assumptions of the
classical model
Describe the short-run determination of
equilibrium real GDP and the price level in
the classical model
Explain the circumstances under which the
short-run aggregate supply curve may be
either horizontal or upward sloping
11-3
Learning Objectives (cont'd)

Understand what factors cause shifts in the
short-run and long-run aggregate supply
curves
Evaluate the effects of aggregate demand
and supply shocks on equilibrium real GDP
in the short run
Determine the causes of short-run
variations in the inflation rate
11-4
Chapter Outline
The Classical Model
Keynesian Economics and the Keynesian
Short-Run Aggregate Supply Curve
Output Determination Using Aggregate
Demand and Aggregate Supply: Fixed
versus Changing Price Levels in the Short
Run
11-5
Chapter Outline (cont'd)

Shifts in the Aggregate Supply Curve
Consequences of Changes in Aggregate
Demand
Explaining Short-Run Variations in Inflation
11-6
Did You Know That ...

The price of a 6.5 oz bottle of Coca-Cola remained
unchanged at 5 cents from 18861959?
Prices of final goods and services have not always
adjusted immediately in response to changes in
aggregate demand.
The classical model and the Keynesian approach
help in understanding variations in real GDP and
the price level.
11-7
The Classical Model

The classical model was the first attempt to
explain:
Determinants of the price level
National levels of real GDP
Employment
Consumption
Saving
Investment
11-8
The Classical Model (cont'd)

Classical economistsAdam Smith, J.B.
Say, David Ricardo, John Stuart Mill,
Thomas Malthus, A.C. Pigou, and others
wrote from the 1770s to the 1930s
They assumed wages and prices were
flexible, and that competitive markets
existed throughout the economy
11-9

Says Law
A dictum of economist J.B. Say that supply
creates its own demand
Producing goods and services generates the
means and the willingness to purchase other
goods and services
Supply creates its own demand; hence it
follows that desired expenditures will equal
actual expenditures
11-10
Figure 11-1 Says Law and the Circular

Flow
11-11

Assumptions of the classical model
Pure competition exists
Wages and prices are flexible
People are motivated by self-interest
People cannot be fooled by money illusion
11-12

Money Illusion
Reacting to changes in money prices rather than
relative prices
If a worker whose wages double when the price
level also doubles thinks he or she is better off,
that worker is suffering from money illusion
11-13

Consequences of the assumptions
If the role of government in the economy is
minimal;
If pure competition prevails, and all prices and
wages are flexible;
If people are self-interested, and do not
experience money illusion;
Then problems in the macroeconomy will be
temporary and the market will correct itself
11-14

Equilibrium in the credit market
When income is saved, it is not reflected in
product demand
It is a type of leakage from the circular flow of
income and output, because saving withdraws
funds from the income stream
Therefore, total planned consumption spending
can fall short of total current real GDP
11-15

Equilibrium in the credit market
Classical economists contended each dollar
saved would be matched by business investment
Leakages would thus equal injections
At equilibrium, the price of creditthe interest
rateensures that the amount of credit
demanded equals the amount supplied
11-16
Figure 11-2 Equating Desired Saving and

Investment in the Classical Model
11-17

Equating Desired Saving and Investment in
the Classical Model
Changes in saving and investment create a
surplus or shortage in the short run
In the long run, this is offset by changes in the
interest rate
This interest rate adjustment returns the market
to equilibrium where S = I
11-18

Question
Would unemployment be a problem in the
classical model?
Answer
No, classical economists assumed wages would
always adjust to the full employment level
11-19
Figure 11-3 Equilibrium in the Labor

Market
11-20
Table 11-1 The Relationship Between

Employment and Real GDP
11-21
The Classical Model (contd)

Classical theory, vertical aggregate supply
and the price level
In the classical model, long-term unemployment
is impossible
Says law, along with flexible interest rates,
prices, and wages would tend to keep workers
fully employed
The LRAS curve is vertical
A change in aggregate demand will cause a
change in the price level
11-22
Figure 11-4 Classical Theory and

Increases in Aggregate Demand
11-23
Figure 11-5 Effect of a Decrease in

Aggregate Demand in the Classical Model
11-24
Keynesian Economics and the Keynesian ShortRun Aggregate Supply Curve
The classical economists world was one of

fully utilized resources
In the 1930s, Europe and the United States
entered a period of economic decline that
could not be explained by the classical
model
John Maynard Keynes developed an
explanation that has become known as the
Keynesian model
11-25
Keynesian Economics and the Keynesian ShortRun Aggregate Supply Curve (cont'd)
Keynes and his followers argued

Prices, including wages (the price of labor) are
inflexible, or sticky, downward
An increase in aggregate demand, AD, will not
raise the price level
A decrease in AD will not cause firms to lower
the price level
11-26
Keynesian Short-Run Aggregate Supply

Curve
The horizontal portion of the aggregate supply
curve in which there is excessive unemployment
and unused capacity in the economy
11-27
Figure 11-6 Demand-Determined Equilibrium Real

GDP at Less Than Full Employment
11-28
Real GDP and the price level, 19341940

Keynes argued that in a depressed economy,
increased aggregate spending can increase
output without raising prices
Data showing the U.S. recovery from the Great
Depression seem to bear this out
In such circumstances, real GDP is demand
driven as the short-run aggregate supply curve
was almost flat
11-29
The Keynesian model

Equilibrium GDP is demand-determined
The Keynesian short-run aggregate supply
schedule shows sources of price rigidities
Union and long-term contracts explain inflexibility of
nominal wage rates
11-30
Example: Have Inflation-Adjusted

U.S. Wages Been Too High?
Unemployment occurs when there is a surplus in
the labor market.
Other things being equal, a labor surplus will begin
to disappear only if the inflation-adjusted wage rate
drops towards the market-clearing level.
Since 2008, inflation-adjusted wages in the U.S. have
declined by about 0.2 percent per year.
Many economists suggest that real wages are not declining
enough to eliminate the labor market surplus.
Consequently, a significant number of workers will remain
unemployed.
11-31
Output Determination Using Aggregate Demand

and Aggregate Supply: Fixed versus Changing
Price Levels in the Short Run
The underlying assumption of the simplified

Keynesian model is that the relevant range
of the short-run aggregate supply schedule
(SRAS) is horizontal
11-32

Price Levels in the Short Run (cont'd)
The price level has drifted upward in recent

decades
Prices are not totally sticky
Modern Keynesian analysis recognizes some
but not completeprice adjustment takes
place in the short run
11-33

Short-Run Aggregate Supply Curve

Relationship between total planned
economywide production and the price level in
the short run, all other things held constant
If prices adjust incompletely in the short run,
the curve is positively sloped
11-34
Figure 11-7 Real GDP Determination with

Fixed versus Flexible Prices
11-35

In the modern Keynesian short run, when the price
level rises partially, real GDP can expand beyond
the level consistent with its long-run growth path.
This is because:
Most labor contracts allow for flexibility in the total
number of hours worked.
The existing capital stock can be used more intensely.
If wages are constant when prices rise, a firm is more
profitable in its operations.
11-36

All these adjustments cause real GDP to rise

as the price level increases:
Firms use workers more intensively, (getting
workers to work harder)
Existing capital equipment used more
intensively, (use machines longer)
If wage rates held constant, a higher price level
leads to increased profits, which leads to lower
unemployment as firms hire more
11-37

Just as non-price-level factors can cause a
shift in the aggregate demand curve, there
are non-price-level factors that can cause a
shift in the aggregate supply curve
11-38

(cont'd)
Shifts in both the short- and long-run
aggregate supply
Includes any change in our endowments of the
factors of production
Shifts in SRAS only

Includes changes in production input prices,
particularly those caused by temporary external
events
11-39
Figure 11-8 Shifts in Long-Run and ShortRun Aggregate Supply
11-40
Table 11-2 Determinants of Aggregate

Supply
11-41
International Example: Australias Short-Run

Aggregate Supply Hit by a Locust Plague
Recently, Australia has experienced its worst

plague of locusts in half a century.
The insects have ravaged large portions of
the nations crops including rice, wheat, and
barley, as well as other crops that are
livestock feed.
These products are important inputs for
many food products.
The result is higher input prices, causing a
leftward shift of aggregate supply.
11-42
Consequences of Changes in
Aggregate Demand
Aggregate Demand Shock
Any event that causes the aggregate demand
curve to shift inward or outward
Aggregate Supply Shock

Any event that causes the aggregate supply
curve to shift inward or outward
11-43
Aggregate Demand (cont'd)
Recessionary Gap
The gap that exists whenever equilibrium real
GDP per year is less than full-employment real
GDP as shown by the position of the LRAS curve
11-44
Figure 11-9 The Short-Run Effects of Stable

Aggregate Supply and a Decrease in Aggregate
Demand: The Recessionary Gap
11-45
Aggregate Demand (cont'd)
Inflationary Gap
The gap that exists whenever equilibrium real
GDP per year is greater than full-employment
real GDP as shown by the position of the LRAS
curve
11-46
Figure 11-10 The Effects of Stable Aggregate Supply

with an Increase in Aggregate Demand: The
Inflationary Gap
11-47
Explaining Short-Run Variations in

Inflation
In a growing economy, the explanation for
persistent inflation is that aggregate
demand rises over time at a faster pace
than the full-employment level of real GDP
Short-run variations in inflation, however,
can arise as a result of both demand and
supply factors
11-48

Inflation (cont'd)
Demand-Pull Inflation
Inflation caused by increases in aggregate
demand not matched by increases in aggregate
supply
Cost-Push Inflation
Inflation caused by decreases in short-run
aggregate supply
11-49
Figure 11-11 Cost-Push Inflation
11-50

Inflation (contd)
Aggregate Supply and Demand in the Open
Economy
The open economy is one of the reasons why
aggregate demand slopes downward
When the domestic price level rises, U.S.
residents want to buy cheaper-priced foreign
goods
The opposite occurs when the U.S. domestic
price level falls
11-51

Inflation (contd)
If the dollar becomes weaker against other
world currencies
A shift inward to the left in the short-run
aggregate supply curve
Equilibrium real GDP would fall
Price level would rise
Employment would tend to decrease
Contributes to inflation
11-52
Figure 11-12 The Two Effects of a

Weaker Dollar, Panel (a)
Decrease in the
value of the dollar
raises the cost of
imported inputs
SRAS decreases
With AD constant,
the price level rises
and GDP decreases
11-53
Figure 11-12 The Two Effects of a

Weaker Dollar, Panel (b)
Decrease in
the value of
the dollar
makes net
exports rise
AD increases
With SRAS
constant, the
price level rises
with GDP
11-54
What If . . . a nations government tries to head off a

recession by pushing down the exchange value of the
countrys currency?
On the one hand, reducing the exchange value of

the currency would make the nations export goods
less expensive in foreign currencies, thereby
boosting foreign spending on home exports.
On the other hand, home-currency prices of inputs
imported from abroad would increase.
Overall, pushing down the exchange value of the
home currency might not necessarily help to head
off an economic downturn.
11-55
You Are There: Worried About Shocks to

Aggregate Supply and Demand
Vincent Hartnett, Jr., president of Penske Logistics,
is confused. He hears the Federal Reserve talk
about fears of deflation. Yet, in his view,
inflationary pressures are abundant:
His firms health care costs have jumped 9 percent in the
past year
Fuel costs and wage levels are on the increase
So, for Penske Logistics, a lower level of output is

associated with every given price level.
He sees this an indication that inflation will
increase, and he expresses concern that the
Federal Reserve may worsen the problem.
11-56
Issues & Applications: Gauging Financial Sources

of Aggregate Demand Shocks
During a two-week period in 2011, the

average value of corporate shares traded on
the U.S. stock market dropped by more
than 15 percent. This erased about $2
trillion of household wealth.
Households responded by reducing their
planned expenditures, and the result was a
negative aggregate demand shock.
The next slide displays the VIX index, a
measure of financial market volatility.
11-57
Figure 11-13 The VIX Index of

Financial-Market Volatility since 1990
Source: U.S. Department of Commerce.

11-58
Issues & Applications: Gauging Financial Sources

of Aggregate Demand Shocks (contd)
Large changes in the VIX index can occur

because of usual world events, or as a result
of shocks in financial markets.
Worries about the financial stability of Greece in
2011 erased $2 trillion of stock market wealth.
The most recent recession is clearly related

to an increase in the VIX index.
Financial shocks were so great that a significant,
prolonged reduction in aggregate demand
occurred.
11-59
Summary Discussion of Learning

Objectives
Central assumptions of the classical model:
1. Pure competition prevails
2. Wages and prices are flexible
3. People are motivated by self-interest
4. No money illusion
11-60

Objectives (cont'd)
Short-run determination of equilibrium real GDP
and the price level in the classical model
The short-run aggregate supply curve is vertical at fullemployment real GDP
Even in the short run, real GDP cannot increase in the
absence of changes in factors of production that induce
longer-term economic growth
Movements in equilibrium price level are generated by
variations in position of AD curve
11-61

Objectives (cont'd)
Circumstances under which the SRAS may
be horizontal or upward sloping
If product prices and wages and other input
prices are sticky, the SRAS curve can be
horizontal over much of its range
This is the Keynesian SRAS curve
11-62

Objectives (cont'd)
Factors that induce shifts in the SRAS and
LRAS curves
LRAS shifts in response to changes in the
availability of labor or capital or to changes in
technology and productivity
Changes in these factors also cause the SRAS
curve to shift
11-63

Objectives (cont'd)
Effects of aggregate demand and supply
shocks on equilibrium real GDP in the short
run
Shock that causes AD to shift leftward and
pushes equilibrium real GDP below fullemployment real GDP in the short run, so there
is a recessionary gap
11-64

Objectives (cont'd)
Effects of aggregate demand and supply
shocks on equilibrium real GDP in the short
run
Shock that induces a rightward shift in the AD
curve and results in an inflationary gap in which
short-run equilibrium real GDP exceeds fullemployment
11-65

Objectives (cont'd)
Causes of short-run variations in the
inflation rate
An increase in aggregate demand
Demand-pull
A decrease in short-run aggregate supply
Cost-push
11-66

Chapter 11 - Miller - Classical and Keynesian

Загружено:

Сведения о документе

Исходное описание:

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Chapter 11 - Miller - Classical and Keynesian

Загружено:

Авторское право:

Доступные форматы

Copyright 2014 Pearson Education, Inc. All rights reserved.

Learning Objectives (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Chapter Outline (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Did You Know That ...

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 11-1 Says Law and the Circular

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 11-2 Equating Desired Saving and

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (cont'd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 11-3 Equilibrium in the Labor

Copyright 2014 Pearson Education, Inc. All rights reserved.

Table 11-1 The Relationship Between

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Classical Model (contd)

Figure 11-4 Classical Theory and

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 11-5 Effect of a Decrease in

Copyright 2014 Pearson Education, Inc. All rights reserved.

Keynesian Economics and the Keynesian ShortRun Aggregate Supply Curve

The classical economists world was one of

Keynes and his followers argued

Copyright 2014 Pearson Education, Inc. All rights reserved.

Keynesian Short-Run Aggregate Supply

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 11-6 Demand-Determined Equilibrium Real

Copyright 2014 Pearson Education, Inc. All rights reserved.

Real GDP and the price level, 19341940

Copyright 2014 Pearson Education, Inc. All rights reserved.

The Keynesian model

Copyright 2014 Pearson Education, Inc. All rights reserved.

Example: Have Inflation-Adjusted

Copyright 2014 Pearson Education, Inc. All rights reserved.

Output Determination Using Aggregate Demand

The underlying assumption of the simplified

Copyright 2014 Pearson Education, Inc. All rights reserved.

Output Determination Using Aggregate Demand

The price level has drifted upward in recent

Copyright 2014 Pearson Education, Inc. All rights reserved.